Riding the bumpy road down

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The long period of anaemic GDP growth is about to stall. The reason why? Because global oil prices have just broken out of their Goldilocks band – the price range in which oil companies can stay in businesses without triggering a global recession.

Last week the Brent Crude oil price briefly hit $80 per barrel – the highest it has been since the oil price collapse in mid-2014; when prices crashed from more than $100 per barrel to just $30. Oil analysts had been expecting an increase in prices this year simply because oil inventories had been running down and shortages were considered likely. However, increased tension between the USA and Iran, together with the collapse of Venezuela’s oil industry has exacerbated the shortage; causing a much sharper spike than had been expected.

The impact of these shifts on the wider economy has been delayed because of the effect of futures contracts. That is, the petrol and diesel that you are currently buying at the pump was sourced some time ago at a lower price. Nevertheless, fuel prices have now risen to the point that it is beginning to hurt, and mainstream media have been obliged to take notice. In the USA, unleaded gasoline is now averaging the ridiculously low (by European standards) price of $2.80 per gallon (0.62p per litre); and there is concern that prices will spike above the symbolic $3.00 per gallon as the summer driving season begins:

“The current level is the highest since 2015, and many experts believe $3 gasoline is right around the corner as the summer driving season heats up. Already, 13% of gas stations across the country have prices above $3 a gallon, according to AAA. Gasoline prices tend to be highest on the West Coast, and nine states — Alaska, California, Hawaii, Idaho, Nevada, Oregon, Pennsylvania, Utah and Washington — already have averages above the $3 mark. Even in the lowest-cost state (Arkansas), average prices have moved above $2.50 a gallon.”

Costs are also rising on this side of the Atlantic; as the BBC reports:

“The price of fuel has hit a three-and-a-half-year high as the price of oil continues to climb, putting more pressure on consumers. The average price of petrol has risen to 127.22p a litre and diesel to 129.96p a litre, following a rapid rise in the oil price…

“This month the price of crude oil briefly reached $80 a barrel and is still at levels not seen since 2014. Last week, the chief executive of French oil company Total, Patrick Pouyanne, said he believed oil could reach $100 ‘in the coming months’.”

Nor is Total’s CEO the only one to raise the prospect of $100 per barrel oil in the near future. Saudi crown prince Mohammed Bin Salman has indicated that OPEC wants to see prices increase above $100 per barrel in order to boost the floatation price of the state oil company:

“Reuters reports that Riyadh would be fine with prices rising that far, which lends weight to the notion that OPEC will keep the production cuts in place even as its mission to drain surplus oil inventories around the world appears to be largely “accomplished.”

“OPEC and its non-OPEC partners are even considering yet another extension that would push the cuts into the middle of 2019. But with inventories back to average levels and expected to fall for the foreseeable future, the production limits would surely push the market into a deficit. The over-tightening, presumably, would lead to higher oil prices…just in time for the Aramco IPO.”

Economists of the neoclassical school – which dominates the thinking of politicians and central bankers – wrongly believe that a rising oil price is inflationary. This is largely because neoclassical economists are taught nothing about money in the course of a three year economics degree:

“It may astonish non-economists to learn that conventionally trained economists ignore the role of credit and private debt in the economy – and frankly, it is astonishing. But it is the truth. Even today, only a handful of the most rebellious of mainstream ‘neoclassical’ economists – people like Joe Stiglitz and Paul Krugman – pay any attention to the role of private debt in the economy, and even they do so from the perspective of an economic theory in which money and debt play no intrinsic role. An economic theory that ignores the role of money and debt in a market economy cannot possibly make sense of the complex, monetary, credit-based economy in which we live. Yet that is the theory that has dominated economics for the last half-century.”

Inflation is not caused by rising prices, but by the devaluation of the currency. That is, provided that the central bank and government maintain the stock of currency circulating in the economy at its existing level, then a rise in the price of oil must result in a fall in prices elsewhere. As Frank Shostak from the Mises Institute explains:

“If the price of oil goes up and if people continue to use the same amount of oil as before then this means that people are now forced to allocate more money for oil. If people’s money stock remains unchanged then this means that less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come off.

“Note that the overall money spent on goods does not change. Only the composition of spending has altered here, with more on oil and less on other goods. Hence, the average price of goods or money per unit of good remains unchanged.”

This is where, in 2008, central banks acted to turn a global slowdown into an existential crisis. It is also where they could easily bring the house of cards tumbling down today. Schooled in the belief that raising interest rates is the cure for rising oil prices, in 2006 the central bankers jacked up interest rates just at the point where rising oil prices were forcing consumers to reallocate their spending. That is, on top of businesses’ and households’ need to adjust to rising fuel prices, the central bankers hit them with additional charges on their outstanding debts. The inevitable result was the wave of defaults in the US housing market and the “credit crunch” of 2008.

One apparent saviour this time around is the US fracking industry that grew dramatically in the wake of the 2008 crash. The standard narrative about fracking is that new technology had unlocked previously unknown shale deposits; and that this had helped drive the oil price down to more manageable levels. For this reason, many media speculators believe that a revitalised US fracking industry will quickly meet the shortages created by OPEC/Russia and drive prices down once more. As the BBC report:

“BP chief executive Bob Dudley has said he expects US shale and increased supply from members of oil producers group OPEC to make up for lost production elsewhere. He predicted the oil price would return to between $50 and $65 a barrel in the near future.”

This would be fine if the received narrative about tight oil was true. Unfortunately, fracking technology has had little impact on oil recovery. The driving factor behind US shale oil was the combination of low interest rates and quantitative easing; which left investors desperate to find above inflation returns. What the fracking industry offered was an interest rate similar to those commonly seen in the years before the crash.

Nor was there much truth to the claim that technology had lowered the cost of recovering tight oil. The lower costs between 2014 and 2017 were largely due to the global oil surplus. Drilling rigs lay idle and their crews sought alternative employment. Supply equipment and materials were left in storage. And in response, these suppliers cut their costs. Today, with demand outstripping supply once more, those costs are going back up. As Irwin M. Stelzer at the Weekly Standard explains:

“Until very recently the received wisdom was that any time the price exceeded something like $50 per barrel, U.S. producers would ramp up production from the ample supplies of shale oil they had tapped using fracking technology, and drive prices back down. Last week the oil market proved once again that it is no more predictable than the stock market: it hit more than $71 per barrel. And is headed higher. (The price of Brent crude, the European benchmark, is about $10 per barrel higher)…

“So where are the frackers? Why don’t they open the valves and flood the market to prevent OPEC from achieving its new target benchmark of $80 per barrel? Because they are constrained by the shortage of labor and materials, and of pipeline capacity in West Texas that is needed to move oil from wellhead to market.”

In short, the breakeven price of fracking rises and falls with the price of oil itself. So the bad news is that all of the talk about the USA being the new swing producer was mere hot air. Of course, in price terms, things would be a lot tougher were fracking not taking place. However, as global oil supplies get tighter and as the price of recovering oil continues to rise, there is little that oil importing states (like the UK and the USA) can do beyond taking the hit.

Which brings us back to the likely impact on the broader economy. Historically, the economy has required an oil price (adjusted for inflation) no higher than $50 per barrel to maintain any GDP growth at all. Indeed, the spectacular period of growth in the two decades 1953 to 1973 were made possible by an oil price of less than $25 per barrel:

Source: Macrotrends. WTI prices 1960-2018

Oil prices in the $50-$80 range cause the economy to stall as businesses and consumers adjust their spending to adapt to the new conditions. At best, prices in this range produce the kind of anaemic growth rates witnessed in the late 1970s and early 1980s and in the aftermath of the 2008 crash. Prices above $80 per barrel cause the economy to crash; and are unsustainable in the longer-term. This is because businesses and households simply cannot adjust to such high prices. Households stop spending and businesses have to lay off workers. Bankruptcies increase and debts become unpayable. As this happens, demand for oil falls back, generating a surplus and lowering prices once more.

If oil was infinite, we could go on like this forever. The problem – reflected in the fortunes of the fracking industry – is that oil is finite. Moreover, we have recovered it on a “cheapest deposit first” basis. That is, we began with oil deposits on land and just metres below the surface. As these ran down, we sought other land deposits in more remote regions like the Libyan Desert. As these ran down, we were obliged to chase expensive deposits beneath the sea bed and in ever deeper water. Today we find ourselves chewing our way through expensive bitumen sands, shale plays and Arctic Ocean deposits each of which cost far more than the $50 per barrel that the economy needs to maintain GDP growth.

Early “peak oilers” believed that as the cost of recovering oil rose, so too would the oil price. This would be particularly pronounced if the energy industry sought to maintain output by adding increasingly expensive synthetic fuels like biodiesel or Fischer-Tropsch conversion of coal into oil. This would be further exacerbated in the event that oil exporting states held on to a larger portion of their oil for domestic consumption. Oil prices four or five times higher than today could be expected in such circumstances.

What this approach overlooks, however, is the ability of the economy to adjust to prices that high. At a household level, today’s rising fuel prices will largely result in shifts in discretionary spending. However, as rising oil prices increase the cost of all goods and services across the economy, this decline in spending elsewhere is likely to be greater. In the end, a growing proportion of spending has to go on oil – both directly as fuel and indirectly in all the things made from or transported with oil – with an equivalent decline of spending elsewhere as non-energy sectors of the economy (such as department stores) are no longer viable: the fall in general economic demand eventually bringing oil prices down once more.

This is what professor A.S. Hall has referred to as the “bumpy plateau” – the point at which the rising cost of producing oil has to balance against the falling ability of businesses and households to absorb the additional cost. For the next decade or so, this dance may well play out with gradually lower price spikes being followed by deeper periods of stagnation and recession. However, in the absence of a lower cost liquid fuel replacement for today’s high cost oil, the days of sustained GDP growth are behind us. Indeed, as the cost of recovering oil continues to rise, we may come to look back fondly on the decade of stagnation we have just lived through and thank our lucky stars that our living standards remained stable. Because thus far nobody has discovered or invented that cheap liquid fuel; and the road across the bumpy plateau we are travelling on is sloping downward.

As you made it to the end…

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